We expect the city of Zagreb will continue posting strong operating margins through 2019

We expect the city of Zagreb will continue posting strong operating
margins through 2019, somewhat mitigating the pressure on capital account
surpluses, since we expect investments will pick up in 2018-2019.

The stable outlook reflects our expectation that the city will continue to
perform in line with our base-case scenario over 2017-2019 and limit
accumulation of debt, both directly and via municipal companies.

OUTLOOK

The stable outlook on Zagreb reflects our view that continued strong operating
balances will help counterbalance Zagreb's increased investment plans. Despite
our expectations of a slight rise in tax-supported debt in absolute terms,
which includes the debt of municipal company Zagrebacki Holding, the city's
debt burden will remain low over 2017-2019.

Downside Scenario

We could downgrade Zagreb if we saw a significant worsening of financial
performance and an increase in tax-supported debt to over 120% of consolidated
operating revenues. We would also consider revising our assessment of Zagreb's
creditworthiness downward if we saw continued pressure on its cash levels,
resulting in further deterioration of its liquidity coverage ratio.

Upside Scenario

Contingent on an upgrade of the sovereign, we could raise the rating if the
city structurally improved its liquidity position, resulting in cash and funds
available under credit facilities covering yearly debt service sustainably by
more than 80%. Additionally, stronger medium- and long-term planning, coupled
with strict oversight of municipal companies, could enhance our view of the
city's financial management and intrinsic creditworthiness.

RATIONALE

The rating reflects our view that the city will continue its trend of high
operating balances, exceeding 10% of operating revenues, allowing room for
more rapid investments. This should enable the city to avoid excessive debt
accumulation and retain its current liquidity position.

Nevertheless, these factors remain counterbalanced by an institutional
framework that is subject to relatively frequent changes, revenue and
expenditure mismatches, and financial management weaknesses. Zagreb's
stand-alone credit profile (SACP) is at 'bb'.

In our view, Zagreb's creditworthiness remains constrained by the
institutional setup under which Croatian municipalities operate. The framework
exhibits frequent changes and an unbalanced distribution of resources that are
not sufficiently aligned to tasks delegated to the municipal level. This is
exemplified by the latest change to the tax system, which took effect at the
beginning of 2017. The tax reform is aimed at easing the tax burden for
individuals and companies by decreasing several tax rates and brackets (for
example, the maximum rate for personal income tax to 36% from 40%). This
effectively diminishes Zagreb's revenue-raising abilities. The reform
stipulates that revenue shortfalls that result will be covered by the central
government through transfers. However, these transfers have not yet been fully
codified by the government. Ultimately, the unpredictability of the central
government's actions constrains policy effectiveness at the city, limiting
Zagreb's ability to effectively plan for the long term.

Milan Bandic was re-elected to serve as the mayor of Zagreb for a sixth
four-year term in June 2017, indicating some stability of the city's
management. Nonetheless, we see management's effectiveness as constrained by
unreliable long-term planning. The use of unconventional debt instruments such
as factoring deals, and a somewhat difficult relationship between the
government and city assembly, as shown by the mayor almost being ousted in
December 2016, further constrain our management assessment.

The city's management of municipal companies remains weak overall. The board
of Zagrebacki Holding maintains very close ties with the city's management,
although clear decision-making procedures appear to be lacking. The city
provides subsidies to Zagrebacki Holding of about Croation kuna (HRK) 580
million (about $90 million) annually. There have been ongoing discussions
between both parties on removing the loss-making transportation company (ZET)
from Zagrebacki Holding's portfolio, but a decision has not been taken yet.
This is an important decision since it would substantially alter Zagrebacki
Holding's financial performance.

Zagreb's economy is diversified. Companies in the city contribute roughly 50%
of all corporate profits in the country, and unemployment has been steadily
decreasing (7.6% in 2016). The pull the city exerts has resulted in a growing
population, which in turn supports the city's economic and tax base. We
estimate that the city housed around 798,500 inhabitants, or 19% of Croatia's
total population in 2016. Furthermore, the city's management continues to
focus on projects intended to promote Zagreb as a tourist and international
conference destination. For example, it is building a new center for corporate
conferences and a network of cycling paths, among various other projects. In
our view, however, these strengths are muted by the country's national GDP per
capita, which is the basis for our assessment of Zagreb's economic profile. We
forecast GDP per capita at around $15,000 in 2019, increasing broadly in line
with sovereign growth trends, but this remains average compared with
international peers'.

In our view, Zagreb's budgetary flexibility is weak. Personal income tax,
which the city cannot modify, accounted for roughly 70% of operating revenues
in 2016. However, the new 2017 tax reforms are effectively decreasing tax
brackets, and personal income surtax is limited at 18%, implying the city's
dependence on the central government regarding taxation matters.

Difficult-to-cut personnel and goods and services expenses represented 37% of
Zagreb's operating expenditure in 2016, limiting its expenditure flexibility.
Furthermore, Zagreb regularly reports payments of subsidies totaling about
HRK700 million annually. Although, theoretically, the city has some discretion
to reduce subsidies, these costs are relatively inflexible, particularly given
the importance they hold for Zagrebacki Holding.

Zagreb's capital program targets transportation infrastructure, street
renovations, and social service facilities. Capital expenditures represent
approximately 11%-12% of expenditures in 2017-2019 and we forecast they will
average about HRK760 million over that period (total of approximately HRK2.3
billion). This, in turn, results in expected surpluses after capital accounts
decreasing to approximately 1.4% in 2019 from 2.7% in 2017 as capital
expenditures pick up in the later years of our forecast. This is also in line
with previous EU-program fund utilization picking up toward the end of the
cycle. The city is also contemplating the possible next programming period,
and its better utilization, in conjunction with the central government.

The city's strong operating surpluses will help limit debt accumulation over
the coming years. We forecast moderate debt intake, principally via Zagrebacki
Holding, while debt issued directly by the city is likely to reduce. In our
base-case scenario, we assume that the city's tax-supported debt, which also
includes debt of other municipal companies and Zagrebacki Holding, will
decrease to 89% in 2018 from 94% in 2016. In our view, this level of debt is
comparably high relative to that of peers in the region, but is generally
neutral to Zagreb's intrinsic creditworthiness, supported by high operating
margins. Direct debt, which includes the factoring deals the city services on
behalf of Zagrebacki Holding, is forecast to decrease to about HRK2.2 billion
in 2019 from around HRK2.4 billion in 2017 (around 35% of operating revenues).
However, we cannot rule out the possibility of an increase in debt, if
operating balances were to be under pressure and Zagreb needed liquidity.

Zagreb's available liquidity remains limited, with the debt-service coverage
ratio just below 60% over the coming 12 months. Zagreb's cash holdings average
HRK240 million per month; we factor into our assessment of maturing debt
liabilities, loans, factoring deals, and guarantee payments. Additionally, we
view access to external liquidity as limited, since Croatia's domestic banking
sector is relatively weak; this is reflected in our assessment of the banking
sector.

In our view, Zagreb's contingent liabilities remain moderate. We factor in
Zagrebacki Holding's payables of HRK600 million as well as the long-term and
short-term debt of self-supporting entities in analyzing the city's total
exposure. The city also has an ongoing legal case against the Ministry of
Finance and previously won a verdict relating to its overdue payables. Given
that the favorable decision effectively reduced the city's payables and the
city made a partial payment to suppliers, its payables now stand at no more
than 10% of operating revenues. We estimate that the maximum loss under a
stress scenario would be 10%-15% of operating revenues.